Chapter 18
The Tools Of Federal
Reserve Policy
©Thomson/South-Western 2006
1
The Federal Reserve Goals and
Tools
 Goals
 influence greater output
 lower the unemployment rate
 prices level stability
 tools of monetary policy or instruments of
monetary policy
 open market operations
 discount window policy
 reserve requirement policy
 intermediate target variables
 short-term interest rates
 monetary aggregates (M1, M2, M3)
2
The Reserve Requirement
Instrument
 Can be considered a “tax” on banks because it
cause bank to hold a larger portion of their assets in
non-interest-earning form (reserves).
 Banks must maintain Reserve requirements or
required reserve ratios that the Fed set.
 Before 1980, reserve requirements only existed for
member banks and ratio for member banks were set
higher than non-members’. Now the ratio apply to all
banks.
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Discount Window Policy
 A facility through which the Federal Reserve lend
reserves directly to depository institutions.




Funds borrowed are called discount loans
Funds are charged at a discount rate
Funds are short-term loan
Transaction is accomplished by a bookkeeping entry, bank
reserves increase with the amount of the loan.
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Discount Window Policy
 Three classes of credit available:
 Primary credit- granted to banks in good condition who are permitted to borrow as
much as they want
 discount rate > fed funds rate
 Secondary credit
 provided to troubled banks that are experiencing liquidity problems
 ½ percentage point higher rate
 Seasonal credit
 provided to banks subject to seasonal fluctuations in loan
demand—like agricultural activity
 Main function of the discount rate today is to set upper
limit on potential movement in the federal fund rate.
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Open Market Operations:
Fundamental Considerations
 Open market operations
 Buying and selling of securities in the open market
 The Fed is empowered to buy or sell




U.S. Treasury securities
federal agency securities
banker's acceptances
other securities
 Domain of Federal Reserve's open market operations could be carried
out in any asset.
 To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S.
government and agency securities and banker's acceptances.
 No matter what items it buys, Fed simply pays with a check written on itself.
 The Fed’s balance sheet impact will always be the same, regardless of the
type of asset the Fed purchases or sells.
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Discovery Of Open Market Operations
And The Banking Act Of 1935
 Accidental Discovery
 Prior to 1920,the discount window was the only Fed policy
tool,
 The Fed's revenues were only the interest received on the
Fed's discounts loans.
 An early 1920s recession led to a drop in revenue, so
individual Fed bought U.S. government securities.
 When Fed purchased securities to compensate for
reducing interest income, interest rates in the market fell,
and credit conditions eased.
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Impact of Open Market Ops
 The Fed conducts open market operation with
the desire to impact:




Short term interest rate
Bank reserves (R)
Monetary base (B)
Money aggregates (the M’s)
 The policy is conduct by selling and buy
securitiessssss
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Impact of Open Market Ops
(Selling)
 If the Fed sells $225 million in U.S. Treasury bills to
a government securities dealer
 reserves and the monetary base contract dollar-for-dollar,
 money supplies directly decrease by dollar-for-dollar
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Impact of Open Market Ops
(Buying)
 When the Fed buys $400 million in Treasury bonds and bills
from banks,
 reserves and the monetary base expand dollar-for-dollar,
But
 the money supply is not directly or immediately affected.
 This happens when banks initiate the multiple deposit-expansion
process by making loans and buying securities.
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Impact of Open Market OpsSummary
 Sell and Buy to Banks
 reserves and the monetary
base contract/expand dollarfor-dollar,
BUT
 the money supply is not
directly or immediately
affected.
 This happens when banks
initiate the multiple deposit
contraction/expansion
process.
 Sell and Buy to Dealers
 reserves and the monetary
base contract/expand dollarfor-dollar,
AND
 the money supply is
immediately contract/expand
dollar-for-dollar.
 The effect to money supply
will be even greater when
banks initiate the multiple
deposit contraction/expansion
process.
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Open Market Operations and the
Federal Funds Rate
 The effects of the Fed's open market
operations transmit very quickly throughout
the nation through the federal funds market.
 The supply of reserves is determined by
Federal Reserve policy.
 When the Fed purchases securities, bank
reserves are boosted dollar-for-dollar. => lower
federal fund rate
 When the Fed sells securities, bank reserves
decline dollar-for-dollar. => higher federal fund
rate
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Figure 18-1
Purchase of Securities
Federal Funds Rate
S1
S2
4.0
3.5
Demand
Reserves
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The Effectiveness Of Open
Market Operations
 Impacts of Open Market Operations via two primary
channels:
 Impact on Bank Reserves, the Monetary Base, and the
Monetary Aggregates:
 The Fed can use relatively accurate control over bank reserves
and the monetary base by manipulating its security portfolio.
 Impact on Security Prices and Interest Rates (Yields):
 When the Fed buys government securities in the open market, it
bids up security prices and therefore reduces their yields.
 Marketable securities are substitutable, so a decline in government
security yields extends to yields on other assets.
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Advantages of Open Market
Operations
 Precision:
 firm and accurate control over aggregate bank reserves
and the monetary base, while
 a high degree of accuracy cannot be achieved through
changes in the discount rate or reserve requirements.
 Flexibility:
 in the market each day, buying and selling large quantities
of securities
 very easy for the Fed to alter course
 Source of Initiative:
 The Fed is able to dominate aggregate bank reserves and
the monetary base.
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Early Disadvantages of Open
Market Operations
 Signaling:
 Changes in the discount rate and reserve
requirements are superior to open market
operations in signaling policy changes to the
public.
 Regional Bias:
 Prior to well-developed financial markets, a
regional bias operated in open market operations,
because the effects were concentrated in select
urban areas where security dealers were located;
open market operations did not disperse across
the nation.
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Technical Aspects Of Open
Market Operations
 Defensive Operations versus Dynamic Operations
 Defensive open market operations
 open market operations made for the purpose of
"defending" bank reserves and the monetary base against
the influence of outside forces
 Dynamic open market operations
 open market operations made to deliberately change the
course of economic activity
 now, from protector to initiator
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Outright Transactions versus
Repurchase Agreements
 Outright transactions
 The Fed uses outright purchases to bring about long-run
or permanent growth in reserves and the monetary
aggregates.
 Repurchase agreements (and reverse repurchase
agreements)
 The Fed uses repurchase agreements (repos) and
reverse repurchase agreements to neutralize the impact
on reserves and the monetary base of transitory changes.
 Recall a repurchase agreement is a money market instrument
wherein one party sells securities with an explicit agreement to buy
them back at a specified future date and price.
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Table 18-1
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